Smart Investor Section 2: Part 2.1 | Part 2.2 | Part 2.3 | Part 2.4 | Part 2.5 | Part 2.6 | Part 2.7 | Part 2.8 | Part 2.9 | Part 2.10 | Part 2.11
Wealth and Investment Management
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1
Smart Investor
Insight into fundamental analysis
“The most important factor to look at when assessing
a possible investment is how much profit it makes.”
Part 2.1
Understanding profits
This is the first of the advanced series of Smart Investor notes. We reviewed the basic
concepts related to JSE-investing in the Basics Series. In this series of advanced notes
we’ll cover issues to help you develop your analytical insight into investing in shares.
This first note considers an often used but seldom examined concept in finance: profits.
They are the point of all investing. So it’s a good place to start.
There are three different levels of profitability,
and each tells you different things:
Gross profit is useful in assessing a company’s pricing
power and its ability to source inputs cheaply. It is simply
the total revenue minus the costs of goods sold. A lower
gross profit margin – which is the difference between the
revenue and cost of goods sold measured as a percentage –
is an indication that input costs are rising or prices are
being forced down, or both. For example, retailers are
facing higher input costs because of growing labour and
energy costs. Mining companies, on the other hand, face
major pricing pressure when international mineral prices
fall, pushing down their profit margins.
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Operating profit is a good measure of a company’s ability
to manage its fixed costs – the rent, salaries of staff and
other costs that don’t depend on sales. When this measure
rises, it indicates that a company is getting a handle on its
costs and overheads. Operating profit is less dependent
on market conditions than the gross margin and is a more
accurate measure of how efficient management is.
Net profit is the bottom line. It tells you how well a company
also manages non-operating costs such as debt, financing
and depreciation of assets. These extra costs reflect less on
management’s ability to operate a profitable business than
the decisions of shareholders on how the company should
be financed.
Introducing profit measures
What is it? Gross profit, operating profit and net profit
and their associated margins are used to measure the
performance of a company.
Why are they useful? Profit margins are a key way of
assessing how well the management of a company is
doing its job. It is helpful to compare margins to peers
as well as to examine margins over time. A company
with shrinking margins is usually one facing increasing
competition and therefore pressure on the prices it can
charge, or facing increasing costs. This can reflect poor
strategy or inefficient operations.
Gross profit
This is the simplest calculation as it reflects total sales less
the cost of sales. “Cost of sales” is the direct variable cost
of a company’s sales activities. It’s easiest to think of it in
terms of retail or wholesale businesses where cost of sales
is the cost of stock. It excludes overheads and other nonsales related costs.
Gross profit = revenue – cost of goods sold
The gross profit margin in that example is 50%,
which is calculated using the basic equation:
Gross profit margin = gross profit/net sales x 100
This figure is particularly useful when making comparisons
between companies in the same industry as it represents
a fair basis for comparison, and reveals quickly who has
higher prices and the better ability to source stock cheaply.
Simply put, if a widget costs you R100 to produce or
buy and you sell it for R200, your gross profit is R100
per widget.
Operating profit
Operating profit is a measure of a company’s operating
efficiency as a whole, including all the expenses it incurs
in its daily business activities.
Operating profit can also be referred to as EBIT (earnings
before interest and tax) or sometimes EBITDA (which also
excludes depreciation and amortisation).
Operating profit is calculated in this way:
Operating profit = gross profit – operating expenses
This produces a figure reflecting the income that is left
after all costs associated with running the company are
deducted. This typically includes the same costs as for
gross margin, and adds overheads such as marketing,
administration expenses and rent, but excludes interest
and tax. For example, in the case of a retailer, its operating
profit includes the cost of stock as well as the cost of salaries,
rental, head office administration, and so on.
The operating profit margin represents the operating
profit as a percentage of sales and measures a company’s
operating efficiency.
The formula is simply:
Operating profit margin = operating profit/net sales x 100
Reducing the profit to a percentage of sales
produces a more accurate means to compare
the relative performance of different companies.
Snapshot
It is important to note that different industries have
differing margins. Retailers tend to have low margins and
focus on high volumes to generate revenue. High-margin
businesses tend to be found where competition is restricted.
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Trading insight
whether a change in profits is sustainable or a once-off,
is critical to knowing whether there is a short-term trading
opportunity available.
Profits are everything to shareholders! When a company
surprises with an earnings announcement or trading
update the share price is likely to respond. Understanding
how to quickly analyse the company’s margins, and
Net profit
This is calculated as:
Net profit margin = net profit/net sales
Net profit is the bottom line profit that is attributable
to shareholders as it reflects the income left after all
expenses are paid, including interest and tax.
The net profit margin, by contrast, shows how much of
each sales rand shows up as net income after all expenses.
Therefore, if a company’s net profit margin is 5%
it means that it generates R5 of net profit for every
R100 of revenue generated.
Here’s a summary of how to think about different “levels” of profit:
revenue
cost
minus cost of sales
revenue
= gross profit
overheads
= operating profit
interest, tax, depreciation
= net profit
this is the part attributable to shareholders
Which kind of company should you invest in?
The most important factor to look at when assessing
a possible investment is how much profit it makes.
The profitability ratios discussed here provide a view
into the profit levels: for example, gross profit can be
expected to be similar for two companies in the same
sector, but the further you drill down to the operating
profit and net profit figures, the better the picture
of how efficiently each company is producing or selling
goods. The higher the margins, the better management
is at sweating more profit out of each rand consumed
in the sales or production process.
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Some examples
The table below shows the operating profit margins
of selected food and clothing retailers. You can see that
clothing retailers enjoy bigger margins than food retailers.
It also looks like the management teams at Shoprite
and Mr Price have been doing excellent work to widen
their profit margins, while Pick n Pay’s shrinking margins
reflect the group’s struggling fortunes of the past few years.
For most companies this is a valuable measurement but
it is particularly useful for companies that operate with high
turnover on low margins, where management is challenged
with trying to increase the percentage profit on every
product produced or sold.
When comparing similar companies, for example
Pick n Pay and Spar, one can quickly tell which is the
more efficient by looking at the operating profit margin.
Operating profit margins (%)
Company
Ave. growth
(%)
2013
2012
2011
2010
2009
Shoprite
Holdings
4.2%
5,78
5,52
5,41
5,03
4,91
Pick n Pay Stores
-21.1%
1,44
2,29
2,77
3,35
3,83
The Spar Group
-2.2%
3,48
3,53
3,69
3,78
3,80
Woolworths Holdings
10.4%
9,80
9,33
8,21
6,99
6,63
The Foschini Group
1.3%
8,10
9,15
8,08
5,99
8,72
Mr Price Group
12.1%
15,10
14,37
13,03
10,49
9,63
2
Part 2.2 – Next we discuss the key measure in fundamental analysis:
the price:earnings ratio.
Click here for part 2.2
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Wealth and Investment Management
Stockbrokers
2
Smart Investor
Insight into fundamental analysis
“The PE ratio is based on historic earnings, but share prices
are all about what the company is expected to deliver
in the future.”
Part 2.2
The PE Ratio
Share prices are not useful in comparing companies because the actual price of a share
is arbitrary. For example, the fact that Anglo American is trading (at the time of writing)
at R214/share and Capitec Bank is trading at R554/share does not mean that Capitec is worth
twice as much as Anglo. Share price levels are largely a function of the number of shares in issue
and can be changed through share consolidations, share splits, buy-backs and new share issues.
In this note we introduce one common way to compare shares – the price:earnings ratio.
Price:earnings ratio
The PE ratio is a ratio of the share price to the latest full
year’s profits of the company per share. In South Africa,
headline earnings per share (HEPS) are used, but this may
vary from country to country. The formula is:
Share price (cents)
HEPS (cents)
If Company A is trading at 100c/share and earned
10c/share in its last financial year, the PE ratio would
be 100c/10c = 10. The share can be said to be trading
on a multiple of 10 times earnings.
But what if Company B is also trading at 100c/share but its
headline earnings were 20c/share in its last financial year?
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The PE ratio would 100/20 = 5. Immediately you can
tell that, even though their share prices are the same,
Company A is actually twice as expensive as Company B.
If you are interested in investing in either share, the next
step in your analysis would be to try to find out why this
is so. The PE ratio is based on historic earnings, but share
prices are all about what the company is expected to
deliver in the future. So if there is a difference in PE ratios,
it must be because the market is expecting different future
performance from the two shares.
Snapshot
What is it? Share price divided by historic earnings.
Why are they useful? It is a quick way to determine
if a company’s share is cheap or expensive relative
to its peers and the general market. It also provides a guide
to the market expectations of a company’s future earnings –
a high PE means the market expects strong earnings growth
in the future.
Why is it not useful? Just going on past earnings is
dangerous. A share price is based on what the market
believes the company’s future earnings will be (see forward
PE below), so a low PE ratio might simply mean the market
is expecting future earnings to be poor.
Live market example
In the JSE’s food retailers and wholesalers category, Pick
n Pay is on a PE of 32.9 (at close of trade on May 4 2015)
and its competitor, The Spar Group, is on a PE of 24.2.
Clearly the market is expecting substantial growth
in earnings from Pick n Pay and less so for Spar. This
places more pressure on Pick n Pay to produce high
earnings, in line with its high PE ratio.
It is impossible to provide a general guide as to what levels
a PE ratio is considered cheap or expensive. For example,
in a bull market when companies across most industries are
growing earnings at a healthy rate, a high PE ratio in itself
should not be a deterrent to an investor as a company
with good historic earnings is likely to meet the market
expectations of higher future earnings.
Very generally though, a PE of around 24 times (like Spar’s)
is not considered cheap but a PE above about 25 times is
usually considered expensive. But it is important that the
retailers meet these expectations.
If a future earnings announcement disappoints the market,
you can expect share prices to move down in response,
bringing the PE ratios lower.
Retailers are currently priced rather high compared with
the rest of the market. As a comparison, the average PE
ratio of the entire All Share Index on May 4 was 19.2, which
is above its historic average of around 14.
Varieties of PE ratio: historic vs trailing PEs
PE ratios are based on historic earnings, usually taking
the company’s latest set of published full-year earnings.
However, if a company has since published a set if interim
results covering the first six months of its financial year,
the historic PE will be out of date.
Analysts then use trailing 12 months’ earnings, taking
the headline earnings from the latest interim results
and adding the headline earnings from the final six months
of its full-year results. That is known as a trailing PE ratio.
Forward PE
As mentioned, a share price reflects what the market
believes about the future earnings of a company, rather
than what the company has actually earned in the past.
The forward PE ratio attempts to determine what the
company’s future earnings will be, so the formula would be:
However, forecasts are just a best guess as to what the
company is going to earn and there is always plenty of
room for error. Usually when the media talk about forward
PEs, they are using the consensus forecasts of professional
financial analysts who publish their earnings expectations.
Share price (cents)
HEPS (cents)
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About PE ratios
PE ratios are a great way to compare companies and
the prices they are trading at. It is a metric that is often
used by “value” investors – Warren Buffett is an oft-cited
example – who assume that the lower the PE, the greater
the value in the company relative to the share price.
One way to think of the PE is as the number of years it will
take for the company to earn its own share price. So a PE
of 10 means the company will take 10 years to generate the
profits to cover the price you are paying for its shares at its
current earnings level.
This is clearer when looking at the earnings yield which
is just the inverse of the PE ratio (“inverse” just means
to divide 1 by the PE). In our example of Company A,
the earnings yield is 1/10 which is 10%.
This shows the “yield” to the investor from the company’s
profits, i.e. the value that the investor derives each year
from holding the stock. This is not the cash you actually
receive, but is the theoretical value that is attributable
to you as the investor.
Final thought
A PE ratio is a useful indicator, but certainly not something
that can be used alone. It is important that you do research
to understand why the PE ratio is low. It may be because
the company is genuinely cheap, or it may be that profits
are going to be under severe pressure in future. You want
to be buying the companies that are genuinely cheap.
3
Part 2.3 – We introduce the PEG ratio which provides a better way to see
the PE in the context of a company’s growth prospects.
Click here for part 2.3
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Wealth and Investment Management
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Smart Investor
Basic concepts used
in fundamental analysis
“Prospective earnings may differ markedly from
historic earnings, and it is future earnings that
a shareholder should be focused on.”
Part 2.3
The PEG Ratio
The PEG (price:earnings/growth) ratio takes the use of the price:earnings ratio – discussed
in our previous Smart Investor note – a step further. The PEG ratio can help determine
whether a high PE ratio simply means a company’s share is expensive or whether it reflects
strong growth prospects. It provides another level of insight to compare companies
in determining which are cheap or expensive.
As we discussed, by understanding a company’s PE and growth prospects, one can
anticipate how earnings announcements and other news will affect share prices when
trading those stocks.
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Introducing PEG ratios
What is it? Price:earnings ratio divided by company’s
earnings growth. It represents the ratio of the PE
to the expected future earnings growth rate.
Why are they useful? It is a more complete measure
than the straight PE ratio of whether a company’s share
price is cheap or expensive, as earnings growth is taken
into account.
Why is it risky?
The PEG ratio relies heavily on earnings forecasts,
which have a wide margin of error. Circumstances
in markets can change quickly. For example, a 5%
depreciation in the rand can have a huge impact
on the future earnings of an exporter, or a rapid rise
in the gold price fundamentally affects the performance
of gold mining companies.
PEG ratio
The PEG ratio is a company’s PE ratio divided by its
percentage growth in earnings for a specified period.
By adding the extra step of dividing by growth, we reveal
whether or not a high or low PE ratio is justified. In South
Africa, headline earnings per share (HEPS) are used.
The formula is:
PEG =
PE ratio
Earnings growth (%)
Example: If a company’s PE ratio (price divided by headline
earnings per share) is 10 and its headline earnings have
grown by an average of 10% a year for the past five years, the
PEG ratio would be 10/10 = 1 (call this example Company A).
The PEG ratio is useful in assessing whether a high PE ratio
is warranted for a company. For example, if Company B’s PE
is 25 times and its five-year average earnings growth
is 10% a year, its PEG would be 2,5 (25/105).
Immediately one can tell that the high PE is not justified
compared to company A. But, there could be an explanation:
that the forward growth scenario is very positive for B.
Prospective earnings may differ markedly from historic
earnings, and it is future earnings that a shareholder
should be focused on. To determine that, one would
have to project what a company’s earnings will be in the
foreseeable future (say three years). Alternatively, analysts
make earnings predictions for most of the JSE’s highly
traded companies and their consensus forecasts can
be used. These can be accessed through some financial
services news websites. Bear in mind though that there
is a high margin for error in forecasting.
Assuming Company B’s projected earnings growth
averages 20% a year, the forward PEG ratio would be
1,25. Immediately one can tell that the high PE is based
on expectations of good earnings growth in the future.
While the PEG of 1,25 indicates it is still on the expensive
side, it is not too demanding relative to expected earnings.
Snapshot
There are variations to the basic formula for a PEG ratio:
PEG = PE/earnings growth (taking all figures from historic earnings)
Current PEG = Current PE/historic earnings growth
Forward PEG = Forward PE/forward earnings growth
Live market example
To take the example from our previous article on PE
ratios further, in the JSE’s food retailers’ and wholesalers’
category, Pick n Pay is on a PE of 32.9 (at close of trade
on May 4 2015) and its competitor, The Spar Group,
is on a PE of 24.2.
Just taking those numbers at face value with Pick n Pay’s
PE nearly 50% higher than Spar’s, the market appears
to be expecting substantial growth in earnings from
Pick n Pay and less so for Spar. Measuring their forward
PEG ratios would indicate if this was so. Projected earnings
are drawn from I-Net Bridge’s consensus forecasts.
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Last 12
months’ HEPS
Projected HEPS:
next financial year
Projected HEPS:
two years
Projected HEPS:
three years
Spar
801,2c (2014)
887,7c (2015)
993,5 (2016)
1089,0 (2017)
Pick n Pay
174,7c (2014)
222,5c (2015)
281,9 (2016)
N/A
Because their financial years differ, it makes it a bit more
complicated to compare the two, so we have made two
calculations: the forward PEG for the next set of results,
and the forward PEG taking the compound annual growth
rate (CAGR) over two years. (See addendum on next page:
Calculating CAGR.)
Company
PE
Projected
earnings growth
for next year
Forward PEG
(1 year ahead)
Projected
earnings growth:
two years
Forward PEG
(2 years ahead)
Spar
24,2
10.8%
2,24
24.0%
1,01
Pick n Pay
32,7
27.3%
1,20
61.4%
0,53
Immediately you can see that it is in fact Pick n Pay which
is the cheaper, relative to expected earnings growth, even
though its PE ratio is twice that of Spar’s. That’s because
Pick n Pay’s growth rate is projected at 27.3% for the next
year while Spar’s is 10.8%.
So the high PE looks much more justified now. The one
year PEG ratio for Pick n Pay is 1.2 and for Spar it is 2.2.
While the PE measure made Pick n Pay look very expensive,
the PEG measure makes it look cheap relative to Spar.
Of course, the pressure is on Pick n Pay to produce those
high earnings that the market expects – should it not
deliver, you can expect serious downward pressure on
the share price to bring the PE back in line with appropriate
earnings expectations.
4
Part 2.4 – We look at the dividend yield, another important measure
to compare shares.
Click here for part 2.4
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Wealth and Investment Management
Stockbrokers
4
Smart Investor
Basic concepts used
in fundamental analysis
“Some companies have an explicit dividend policy,
usually expressed as a percentage of profits that
will be paid to shareholders.”
Part 2.4
The dividend yield
Cash never lies, goes the old adage. That’s true in all sorts of fundamental analysis.
From a shareholder perspective, there is no more important form of cash than the
dividends you receive from shares you own.
Not all companies pay dividends, sometimes for good reason. But, depending on what
your objectives are, the dividend yield of a company is always an important component
to consider. (You may want to review note 4 in our Basics series on the sources of returns
for shares to get the background).
The formula:
The dividend yield is the amount of dividends paid out
expressed as a percentage of the share price:
dividend paid (cents) x 100
share price (cents)
For example, if two companies both pay annual dividends
of 100c/share, but Company A’s share price is R20 and
Company B’s is R40, Company A has a dividend yield of 5%
and Company B has 2.5%. Assuming all other factors are
equal, an investor looking to supplement his or her income
would likely prefer Company A’s stock.
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Snapshot
What is it? The profits a company returns to shareholders
as a percentage of the share price.
Why are they useful? The dividend yield is a very
important component of a shareholder’s returns and
a key ratio used in fundamental analysis. It allows for
comparisons between different shares based on the
hard cash paid out to shareholders.
What do you need to know? Some companies pay
dividends, others do not, but opt to reinvest profits
to grow the company. There are two components to
returns you get from owning a share – the dividend
and the capital appreciation of the value of the share
itself. These two elements are in tension with each
other. The more a company pays out in dividends,
the less cash it will have to fund growth, so the lower
the capital appreciation in the share price is likely to be.
Historic dividend yields
Dividend yields quoted in the media are historic dividend
yields. Companies pay out dividends once or twice a year,
and the dividend yield reflects the dividends paid in the past
12 months. Sometimes analysts forecast what dividends a
company is expected to pay and calculate a yield based on
this expectation. This represents the forward dividend yield.
One weakness of the historic dividend yield is its backwardslooking nature. Like many other indicators based on historic
information, it is risky because the company’s prospects
may change. A share price reflects what the market believes
about the future prospects of a company. Some companies
may have a high dividend yield because of their last dividend
payment, but will not be able to pay such a dividend in future.
Dividend payers versus non-payers
The decision on whether or not to pay a dividend rests with
the board and the essential question directors should ask
is: would our company be able to generate better returns
from the cash than shareholders could earn if they gave
the money back to them?
If the company is in a high growth phase, shareholders will
be better off if the company uses its profits to fund future
growth. This provides a better return than shareholders can
get on the cash. This relationship is clear on days that
a company goes “ex dividend”. This is the set date when
the dividend is declared and buyers of the share are no
longer entitled to the dividend. If a company goes ex
dividend on 11 October, you would receive the dividend
payout if you buy the share on 10 October, but not if you
buy it on 11 October. On 11 October the share price will fall
by the amount of the dividend.
There is also an important tax consideration. When
a company pays a dividend the shareholder has to pay
dividend tax at a rate of 15% on the payment (in South
Africa the company retains this and pays SARS directly.
The dividend tax replaced the secondary tax on companies
in April 2012). However, if the company does not distribute
its profits and instead uses them to fund growth, there
is no dividend tax payable. So it is more tax efficient for
companies not to pay out dividends – shareholders get
their returns in the form of capital growth. Of course,
capital gains tax is then payable on this growth, but
this is at least deferred until you actually sell the shares.
Some companies have an explicit dividend policy,
usually expressed as a percentage of profits that will
be paid to shareholders. For example, a company may
have a policy of paying 50% of after-tax earnings per share
to shareholders. This would then balance the need to fund
its own growth with the desire of shareholders to receive
some cash income.
Few companies would pay out 100% of their profits,
although there are some that do. Property companies
usually do because they have no need to retain profits.
But a dividend policy is seldom a commitment to always
pay a dividend; if the company is not profitable, it will
most likely not pay anything. However, there are exceptions
to this: sometimes a company will still pay a dividend out of
its cash reserves if it believes the cash is surplus to its needs.
Companies sometimes also pay out a special dividend,
which is exceptional and should not be treated as the
norm. This sometimes happens when a company gets
a large, exceptional cash inflow such as when it disposes
of an asset. For example, Old Mutual paid out a special
dividend of £1bn in 2012 after it sold its Nordic subsidiary.
Special dividends are meant to be seen as outside
of the normal dividend policy and should not
be included in calculations of the dividend yield.
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Snapshot
A dividend yield is an important indicator, allowing for
comparisons between companies and to understand
whether the company will be able to generate income,
if that is what your objective as an investor is. It should
be looked at in conjunction with the company’s dividend
policy. And, as with all investing, one has to assess what
the prospects of the company are in order to understand
whether it will reliably pay dividends in future.
Growth versus value
A dividend yield, like a PE ratio (reviewed in note 2),
is used as an indicator of “value” versus “growth”
companies. A high dividend yield can indicate a company
that is relatively cheap compared with other companies.
On the other hand, a company that has a low or zero
dividend yield usually indicates a growth company
that is expected to grow earnings in the future.
When undertaking fundamental analysis a key theoretical
assumption is that shareholders will receive cash from
shares at some point in the future. What we are really
doing is estimating how much that cash will be and
what the right price is to pay for the right to receive that
cash. Owning a share really just means having a right to
a portion of the future profits of the company. So even
when a company pays no dividends at all, we are implicitly
assuming that one day it will, and that’s why we own the
share. A growth company pays no dividends but we are,
at least in theory, counting on the company paying out
a much larger dividend in future.
One indicator that can tell us whether a company should
pay out its dividends or keep them to fund growth is return
on equity (see Smart Investor note 6). When return on
equity is high it may be preferable for the company to hold
on to profits, increasing the amount of equity on its balance
sheet, and thereby ensuring higher future profits.
Some investors depend on income from their share
portfolio. Retirees, for instance, may want to hold reliable,
high dividend yield stocks to provide for their basic needs.
For this reason, high dividend yield stocks are sometimes
called income stocks. Other forms of yield instruments are
bonds which pay out a fixed amount of interest.
For example, Vodacom has over the past few years
switched from being a growth company to a value company.
It currently (28 May 2015) has a dividend yield of just about
5.6%, which is above average. It pays out most of its profits
now, having reached a plateau in its growth rate.
Trading insight
There are two dividend-related issues that can lead
to short term share price movements. First are dividend
surprises, when a company that is expected to pay
a dividend doesn’t, or else a company unexpectedly
announces a dividend. These are seen as signals about
the health of the company. Second, when a company goes
ex-dividend, there is often a disproportionately large fall in
the share price. Some traders exploit this by trading around
the ex-dividend date.
Examples of dividend yields
We have selected stocks of interest. The low dividend
payouts by Naspers and Aspen can be justified as they
are growth stocks while Barclays Africa Group and
Vodacom have high dividend yields, implying less potential
for growth. Massmart’s “middle of the road” dividend yield
is perhaps reflective of a company with growth plans but
believes it can still return a decent amount of cash to
investors, and currently (28 May 2015) has a dividend
yield of just about 5,6%, which is above average. It pays
out most of its profits now, having reached a plateau
in its growth rate.
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Five dividend yields on the JSE (large non-property companies)
Company
Dividend yield
Vodacom
5.66%
Barclays Africa Group
5.14%
Massmart Holdings
2.47%
Naspers
0.23%
Aspen Pharmacare
0%
5
Part 2.5 – In our next note we discuss net asset value.
Click here for part 2.5
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Smart Investor
Basic concepts used
in fundamental analysis
“To make sense of the relationship between the share price
and the NAV, we often look at the price-to-book ratio, which
expresses the share price as a multiple of the NAV/share.”
Part 2.5
Net asset value and price: book ratio
Net asset value (NAV) is one measure of the value of a company. It simply considers its assets
net of any liabilities. It is the value that is attributable to shareholders, rather than lenders
or suppliers who are owed money. In theory, it is the value that could be derived by liquidating
the company, although if this were actually done there would probably be tax liabilities
generated that would absorb some of the NAV.
Snapshot
What is it? The net asset value (or book value) of a company
is the value shareholders can really count as their own.
It is the amount left over once all a company’s liabilities
are deducted from its assets.
Why are they useful? The NAV is a bottom-line value that
does not depend on forecasts of future cash flows and so
is often a more reliable indicator of value. A company
should trade at least at its after-tax NAV, or else
shareholders should demand that it be liquidated.
Why is it risky? It does not take cash flows into
account, and while the company’s assets may be
substantial, it is not always easy to unlock the value
for shareholders.
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To determine the net asset value, we have to consult the
financial statements of a company, in particular the balance
sheet, which in most annual reports is called the “statement
of financial position”. The NAV is the company’s assets less
the company’s liabilities.
For example, consider the following abridged balance sheet
(which is from Tiger Brands’ interim report for March 2015).
ASSETS
Property, plant and equipment
Goodwill
Intangible assets
Investments
Rm
5 680
2 384
1 060
3 448
Current assets
Total assets
11 054
24 928
LIABILITIES
Total equity
Non-current liabilities
Current liabilities
Total equity & liabilities
Rm
14 145
1 313
9 469
24 928
To determine the NAV, we deduct liabilities from assets. So:
NAV
=
=
=
Total assets – total liabilities
R24 928 – (R1 313 + R9 469)
R14 145 (in Rm)
Snapshot
Variations of NAV are used for certain types of companies.
When valuing mines, for example, in-situ NAV can be used
– the mine’s measured, indicated and inferred mineral
resources, less its liabilities. Some analysts value mines
on a weighted average or multiple valuations using different
methods (typically in-situ NAV plus discounted cash flow).
You can see that this is equal to the “total equity” line
of the balance sheet, and usually you can determine
NAV by looking at the total equity. Sometimes, however,
equity includes elements that are not attributable to
ordinary shareholders, such as preference share funding.
That should be properly considered as a liability. On the
other hand, sometimes current and non-current liabilities
include shareholder loans. It would then often be better
included with equity.
issue on a fully diluted basis. That means that the NAV/
share is R73.64. The Tiger Brands share price at time
of writing (28 May) is R290.85.
NAV is often expressed in terms of NAV/share. To get
this number you divide the NAV by the number of shares
in issue (usually in the annual report). At the time of this
balance sheet, Tiger Brands had 192 069 868 shares in
This is a fairly high price-to-book ratio which shows the
market values the company at about four times the value
of its net assets. So shareholders are expecting it to be
very profitable and earn high returns out of its assets.
To make sense of the relationship between the share price
and the NAV, we often look at the price-to-book ratio,
which expresses the share price as a multiple of the NAV/
share. So in this case, Tiger Brands’ price-to-book ratio
is 290/73,64 = 3,95.
TNAV
There is one further important measure, the tangible net
asset value (TNAV). “Tangible” assets are physical assets
you can see and feel, as distinct from intangible assets
such as intellectual property and goodwill.
“Goodwill” is an accounting fiction that is used to account
for premiums paid when buying another company. For
example, were a company to buy Tiger Brands at its current
share price and then consolidate Tiger Brands’ balance sheet
onto its own, there would be a significant difference between
the price it paid and the net assets it would acquire (indeed,
it would pay four times the value of the assets). Accountants
solve this dilemma with the fictitious asset they call goodwill.
You can see on Tiger Brands’ balance sheet that it has R2
384m-worth of goodwill, which represents the premium
it has paid for companies it has acquired over and above
the assets of those companies. But were the company to
be liquidated, this fictitious asset would be worth nothing.
Also, Tiger Brands has R1 060m-worth of other intangible
assets, which may consist of brands, software, patents and
so on. We usually don’t think of these as “real” assets either.
We are generally cautious about intangible assets because
there is a lot of management discretion involved in how they
are valued and there have been plenty of examples in the
corporate history of shareholders being misled about the
values of companies through inflated intangible assets (the
Corpcapital and Regal Treasury Bank scandals a decade ago
are examples).
We therefore often calculate the TNAV by excluding the
intangibles from the total assets. When this is done for
the Tiger Brands case, TNAV comes out at R55,71/share.
Quite a bit less than the NAV.
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Trading insight
Sometimes a share price goes out of whack with its
component assets. For instance, the value of Anglo
American depends substantially on its exposures to Kumba
Iron Ore and Anglo Platinum. The share price of the holding
company should exhibit some relationship with the share
prices of its subsidiaries. When this relationship breaks
down it is often a signal of a trading opportunity.
Other companies have assets in the form of large
inventories like commodities of copper. If the value
of the inventory changes, the share price should too.
Traders can arbitrage these two values.
Why it’s useful
NAV is particularly useful when it comes to investment
holding companies, property companies and unit trusts,
the value of which really do consist of their assets.
For investment holding companies, which consist of a
variety of interests in other companies, for example, NAV is
a useful tool to determine whether they are trading above
or below the sum total of the value of the underlying
investments. In theory, the holding company should
equal the sum of the parts, less any capital gains tax
and dividend tax, and the costs of the holding company
management layer.
As is clear, a company’s share price is often lower or higher
than its NAV. This does not automatically mean it is under-
or overvalued; share prices are a factor of historical
information plus expectations of future earnings.
If a company is trading above its NAV per share,
it indicates that investors believe it has good growth
prospects so are prepared to pay more for it. In other
words, they believe the forward NAV will be higher.
Investment holding companies usually trade below their
NAV per share – but this does not necessarily mean they
offer value. Rather, the discount reflects the added layer
of costs involved in an investment holding company
structure (auditors, a board and executive committee
with subcommittees and administrative costs) and the
tax implications of liquidating it.
EV/Ebitda ratio
Known as the “enterprise multiple” or the “Ebitda multiple”,
this ratio is a comparison of enterprise value (EV) before
interest, taxes, depreciation and amortisation. It values a
company, including debt and other liabilities, to the actual
cash earnings excluding non-cash expenses. The enterprise
value is the same as the net asset value, therefore the
formula is:
EV/Ebitda ratio =
NAV
when a company raises equity finance to pay off debt,
it usually results in lower earnings per share.
Another benefit is that the Ebitda ratio can be used to
compare companies with different capital structures.
Finally, the Ebitda ratio removes the effect of non-cash
expenses such as depreciation and amortisation and
makes cash flows the key component.
Ebitda
The Ebitda multiple is a better measure of a company’s
value than the PE ratio because it is not affected by
changes in a company’s capital structure – for example,
6
Part 2.6 – In our next note we look at a key measure
of profitability, return on equity (RoE).
Click here for part 2.6
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Smart Investor
Building insight into trading shares
“A low RoE suggests that shareholders would be better off
if the company gave the cash back to them, while a high
RoE suggests shareholders would be better off giving the
company more cash.”
Part 2.6
Return on Equity (RoE)
This is the first in a series of notes on ratios that reflect the profitability of a company,
beginning with return on equity.
To determine RoE, simply divide the company’s headline
earnings by shareholders’ equity. That is the practice
in South Africa, but in other countries profit after tax
is used as the profit measure. The headline earnings
measure removes some once-off income statement
lines, so it attempts to capture sustainable earnings
before dividends are paid out. You can find it in any
company’s reported financials as well as the net equity
figure. Shareholders’ equity, found in the balance sheet,
excludes preference shares and is usually used as an
annual average – the average of the opening and closing
balances on the balance sheet.
The formula is:
RoE =
headline earnings
shareholders’ equity
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Snapshot
What is it? RoE represents the profits the company is able
to generate as a percentage of the shareholder funds that
it holds.
What does it do? Companies have a choice on how to
structure their balance sheets. If they hold shareholders’
funds – often called equity – that money should be working
for shareholders. RoE shows how hard that money is working
for shareholders. It is one measure of the efficiency of the
balance sheet, showing that it has the right balance of debt
and equity.
Why is it useful?
For one, it shows how well a company is using money
that belongs to shareholders. A low RoE suggests that
shareholders would be better off if the company gave the
cash back to them, while a high RoE suggests shareholders
would be better off giving the company more cash.
RoE is also a useful input to guide forecasts of a company’s
growth. If the amount of shareholder capital a company
holds is the main determinant of its ability to grow, RoE
indicates how profits may grow in future. For example, if
a company has an RoE of 10% and its shareholder funds
double from year 1 to year 2, we would expect the profits
to double as well, provided the RoE stays the same.
Note, however, that the usefulness of RoE depends on what
industry you are looking at as well as the specific company.
Some industries are not very capital intensive and so have
higher RoEs, for example, services companies which have
very little capital equipment they need to finance. Other
companies are very capital intensive so have low RoEs,
such as mining or telecoms companies.
Capital-intensive companies often have less competition,
because having a large balance sheet provides an effective
barrier to entry while high RoE companies often face more
competition over time. For that reason, RoE is most useful
when comparing companies within an industry or when
judging the performance of a company over time.
In some companies the amount of shareholder capital
is a more critical determinant of growth than in others.
For example, banks are legally required to hold a certain
amount of capital for every loan that they make. So having
more equity increases the amount of lending they do. RoE
therefore becomes important in determining whether the
bank should be increasing or reducing its lending. A bank
with a high RoE should be increasing shareholder funds
in order to expand its lending potential.
Snapshot
RoE can be a useful tool when assessing companies.
It is particularly useful to study trends in a company’s
performance – an improving RoE shows a company that
is improving the efficiency of its balance sheet and its
profitability. It is also a useful tool to start to predict the
growth trends in a company.
The Du Pont formula
Financial analysts often break RoE down into three different
parts in order to analyse what causes changes in RoE over
time. Remember that the basic formula (above) has profits
at the top and shareholder funds at the bottom. By factoring
out that equation, one can tease out the different things that
affect RoE. The basic three-term Du Pont formula is:
RoE = net income
sales
x
sales
average total assets
x
average total assets
average shareholder equity
You can “cancel out” the same numerators and
denominators in the Du Pont formula to end up back at the
basic RoE equation again. But teasing out these three terms
in the equation gives us three well-known ratios:
• Net profit margin is the profit (“net income”)
as a percentage of sales
• Sales over total assets represents the total asset turnover
• Total assets over shareholder equity represents the
financial leverage ratio and indicates how indebted
the company is
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The Du Pont formula helps identify what is driving RoE
in a company. High profit margins, a high turnover relative
to the assets on the balance sheet, and a high leverage ratio
translate into high RoEs.
If the net margin increases, it means every sale brings
in more money, resulting in a higher overall RoE. Similarly,
if the asset turnover increases, it means the company
generates more sales for every unit of assets owned, again
resulting in a higher overall RoE.
Finally, increasing financial leverage means more debt
financing is used relative to equity financing. Interest
payments are tax deductible but dividend payments to
shareholders are not. Thus, a higher proportion of debt
leads to higher RoE. However, as the level of debt rises
and the risk of default increases, the benefit diminishes
as the cost of the debt rises because creditors demand
a higher risk premium, and RoE decreases.
Increased debt will make a positive contribution
to a company’s RoE only if the matching RoE of that
debt exceeds the interest rate on the debt.
Market example
We’ve calculated the Du Pont formula for Mr Price, the
JSE-listed retailing company, for its 2014 financial year (all
these figures come from the annual reports on the Mr Price
website). The company had equity of R3 992m at the end
of 2014 and R3 309m at the start, so the average for the
year was R3 651. It had headline earnings of R1 888 at the
end of the year. This means RoE was a very healthy 52%.
To make sense of the key drivers of this figure, we can break
down the RoE into the Du Pont formula (all Rm):
R1 888
R12 122
x
R15 892
R5 731
R5 731
x
R3 651
From this formula we can determine that Mr Price’s profit
margin is 12%, its asset turnover is 2,1 times and its
leverage ratio is 157%. But if we look at the same formula
for Mr Price for the year before, this is what we get:
R1 537
R13 720
x
R13 720
R4 597
x
R4 597
R3 049
Now we can see the profit margin is 11.2%, the asset
turnover is 3,0 times, and the financial ratio is 150%.
This gives a total RoE of 50%, so RoE improved between
2013 and 2014. And we can see that it improved because
profit margins increased (from 11.2% to 12%) but its asset
turnover fell from 3 to 2.1. This means it is holding more
stock relative to the sales it is making in 2014 compared
to 2013. Its leverage ratio was also slightly higher in 2014,
which helped RoE.
So this exercise tells us some important things. Mr Price
did well to increase its sales margins, but did less well in
the efficiency of its stock.
From here, to forecast Mr Price’s earnings we’d want to
know what was going to happen to margins in the year
ahead, whether it would turn over its stock faster and
whether it would increase debt. Getting answers from
management on those questions would allow us to
forecast what growth is going to be and therefore what
future profits will be.
Problem areas
As with most financial ratios, there are variations in ratio
definitions which may cause problems.
Numerator (the profit measure at the top): Which profit
number should be used, before or after taxes? How should
it be adjusted for non-recurring items? Should operating
profit figures be used (earnings before interest and taxes,
or earnings before interest, taxes, depreciation and
amortisation) or earnings attributable to shareholders?
Denominator (the measure of equity at the bottom):
A balance sheet figure is for a specific point in time (the
year-end or interim period) while the numerator is for a full
reporting period. While the most common usage is for an
7
annual average, some use equity at the beginning of the
year or the figure at year-end. In certain companies there
may be difficulties with knowing which figures to include
in equity, such as when the company is financed with
shareholder loans (which could be either debt or equity,
depending on the context).
Be careful of using the list of computer-generated RoE
figures provided for companies on some financial websites
– if the company is running at a loss and if the shareholders’
equity itself becomes negative, the RoE figure will still read
as a positive because you’re dividing a negative figure with
another negative figure, but such a company would be
technically insolvent!
Part 2.7 – We examine cash flows, the numbers that never lie.
Click here for part 2.7
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Smart Investor
Basic concepts used
in fundamental analysis
“Assessing the relationship between profits and cash
flows is an important measure to verify what a company
is reporting in its financial statements.”
Part 2.7
Cash flow – the king of financial analysis
Understanding the implications of a business’s cash flow on its sustainability is an invaluable
insight that can help you better assess the performance of a company.
A company’s accounts can get murky very quickly.
Accounting works on the principle of accrual, which
means costs and income are recognised at the time they
are incurred, rather than when the cash is actually received
or spent. Investors like to say “cash never lies” because
the actual receipt of cash is when you know for certain
that money has been earned.
Aggressive managers can find ways to manipulate the
accrual system to show profits that will never actually
lead to real cash.
For instance, a company may report higher sales and profit
by virtue of a sales campaign that offers liberal credit terms,
although this may lead to liquidity problems or bad debts
down the line that might not be immediately apparent.
For this reason, we explore the different types of cash flow
that will be reflected in a company’s financial statements under
the Statement of Cash Flows section. These different measures
produce a cumulative picture of cash in and cash out.
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Snapshot
What is it? Cash flow is an indicator of the in and outflow
of hard currency in a business.
Why is it useful?
Cash really doesn’t lie. Assessing the relationship between
profits and cash flows is an important measure to verify what
a company is reporting in its financial statements.
Why is it risky? Cash in the bank is a metric that can
be checked fairly easily, although it is equally important
to examine the sources of cash flow. A company that has
negative cash flows from operations must be either selling
assets or raising finance from somewhere to sustain itself.
Operating cash flow
The basic source of cash for a company is its sales, and the
basic use of cash is payments to suppliers. These cash flows
make up the operating cash flow of a firm. Cash generated
from operations differs from the turnover or revenue figure
in that it strips out the effect of sales on credit or credit
received from suppliers.
Shoprite Operating cash flow
The cash flow statement shows you this figure, but is related
to the income statement and balance sheets by adjusting
revenue for changes in current debtors and creditors. Any
income received from the revelation of investments and other
non-operational items also need to be removed from the
calculation to get an accurate operating cash flow picture.
June 2014 (Rm)
Plus increase in payables
3 658
Interest received
252
Interest paid
-342
Dividends received
30
Dividends paid
-1 868
Income tax paid
-937
Total operating cash flow
5 720
For example, consider the cash flow statement of Shoprite
above. It is a high-volume cash retailer, so its cash flows are
quite considerable. The cash generated from operations
is slightly higher than the operating profit figure (R5.708bn
compared to R5.72bn). Looking at the reconciliation of the
two shows why this is the case. Non-cash costs include
depreciation and amortisation which are costs, but are not
cash costs, so these can be added back to the operating
profit. But the company saw an almost R2bn increase in
inventories, probably because it opened new stores during
the period. It also had more receivables, which is the cash
that is owed by its customers, so although it books this as
income, it doesn’t get the cash. What really helped matters,
though, is that Shoprite squeezed suppliers with a R3.6bn
increase in its payables – the money it owes suppliers. This
is good for cash flows, but can be unsustainable if suppliers
start pushing back.
Investing cash flow
These items are an important indicator of a company’s
investment in new factories and machines, subsidiary
companies, any financial instruments like bonds and
shares as well as any proceeds from the sale of any such
assets. Using the example of Shoprite again, its cash flow
from investing activities was:
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Shoprite Operating cash flow
June 2014 (Rm)
Investment in property plant and equipment to expand operations
3 658
Property, plant and equipment to maintain existing operations
252
Proceeds from the sale of property, plant and equipment
-342
Other investing proceeds
30
Investment in associates
-1 868
Acquisition of subsidiaries and operations
-937
Total cash flow utilised by investing activities
5 720
Here you can see that investing cash flow was strongly
negative at -R4.2bn largely because Shoprite has been
investing in expanding its operations, such as opening new
stores, at a cost of almost R3bn. It sold some assets
to generate a relatively small amount of R126m of investing
cash inflow. Everything else was negative.
Cash flow from financing activities
The last item reflecting monetary inflows is cash received
from shareholders or lenders that a company receives
in return for issuing new shares in the first case
Shoprite Operating cash flow
Proceeds from ordinary shares issued
and through issuing bonds or obtaining loans in the
latter. In the case of Shoprite, cash flow from financing
activities was:
June 2014 (Rm)
0
Proceeds from convertible bonds issued
224
Increase in bank loan
229
Total cash flow from financing activities
453
So here we can see that Shoprite borrowed R453m during the
year to finance its business, through a combination of issuing
bonds and bank loans. By looking at the cash flows broken
down into operating, investing and financing, we can see that
Shoprite is using the cash flows from its operations (largely
generated by squeezing suppliers) to fund its investment
in new stores. Some borrowing has also added a bit, while
it has also paid out a fair bit in dividends.
Interest, dividends and tax
An area of cash flow accounting that causes some
confusion is the treatment of interest and dividend payments.
The reason for this is that it is not always clear where these
inflows are accounted for within the framework of the three
types of cash flow explained above.
There is greater clarity for financial institutions in accounting
for this as such inflows should be treated as operating cash
flows, given the nature of the business model. But in other
companies it is less clear and accountants are usually free
to decide for themselves.
In the case of Shoprite, it specifies its interest, tax
and dividend payments as part of operating cash
flow, shown above.
The sum of all these calculations is reflected in a company’s
financial statements as the net movement in cash and
cash equivalents. In Shoprite’s case that was a positive
R2bn. That is a positive sign for investors and indicates high
quality earnings in a business that is able to fund its growth
out of operating revenue.
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The games execs play
South African corporate history is littered with examples
of companies that have booked big profits, allowing execs
to pay themselves big bonuses. But when the cash flows
are examined it becomes clear they have been selling
assets or simply handing out credit to boost sales figures.
Those types of games can only be played for so long.
8
Part 2.8 – Discounted cash flow modelling.
Click here for part 2.8
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Wealth and Investment Management
Stockbrokers
8
Smart Investor
Basic concepts used
in fundamental analysis
“The accrual principle in accounting can lead to a company’s
cash flow from operations differing from its earnings.”
Part 2.8
Cash flow ratios
In our last note we discussed cash flow statements and how to understand them. In this note
we consider some analytical tools that can be applied to cash flow statements in order to tease
out important information about companies’ performances.
The cash ratio: operating cash flow/operating
profit ratio
This ratio is the starting point in assessing the quality
of earnings of a company. It is a quick way to determine
just how much of a company’s operating profit comes
from non-cash items.
Operating cash flow is one way to assess the quality
of earnings of a company. Alarms should go off if it’s booking
profits but not receiving any cash. Cash flow is also important
to understand the company’s liquidity position.
You can assess whether it is able to meet all its
obligations when due, particularly payments to lenders.
Cash flow also provides an important measure of returns
to shareholders: the free cash flow. We discuss how
to use each of these below.
The ratio expresses the total “cash flow from operations”
(which can be found in the cash flow statement) and the
total revenue as a percentage:
Cash generated from operations x 100
operating profit
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Snapshot
What is it? Cash flow ratios provide powerful financial
analysis tools that help determine how healthy a company
is, particularly regarding earnings quality.
Why is it useful? Cash flow is important to understand
a company’s liquidity position as it will help you assess
whether it is able to meet all its obligations and provides
a critically important measure of returns to you as
a shareholder.
When calculating this ratio, we use cash generated from
operations excluding any interest and dividend payments
(we discussed this issue in our previous note).
In our last note we discussed Shoprite as an example and
showed it had total operating cash flow of R5.72bn while its
operating profit was R5.708bn. This implies a cash ratio of
slightly more than 100% because it gets more cash than its
profits – 100.2%, to be exact.
What to look out for? The accrual principle in accounting
can lead to a company’s cash flow from operations differing
from its earnings. Clever accounting can therefore make
a company’s profits look really good, but in reality they are
accounting oddities rather than real cash earnings.
Companies with a ratio higher than 100% show healthy
cash-generating ability.
For cash retailers such as Shoprite, this ratio tends to
be above the 100% mark if they manage their creditors
‘correctly’ by paying them as late as possible. As we saw
in the previous note, Shoprite generated a lot of cash by
paying its suppliers later than the previous year.
Trading insight
Ultimately the value of any financial asset depends on the
cash flows it delivers to the owners of that financial asset.
If the ratio is below 100%, check to see why. Usually it’s
because the company has been selling more on credit.
Then, check if the company is able to efficiently obtain
the cash for such sales. In other cases it is because it
is revaluing assets, an issue common in investment
companies. Sometimes it is legitimate, but valuations
upwards are always rather convenient for management.
Be sceptical.
Danger alert
The cash ratio can pick up serious problems in reported
results. One celebrated example was Corpcapital, which
in 2001 reported an operating profit of R387m but
operating cash flows of R205m – so its ratio was 53%.
This raised alarms and a study of the cash flow statement
made it clear that significant income was being booked for
adjustments to the value of investments the company held.
In effect it was booking profit by revaluing its investments
– a non-cash form of income. One in particular was highly
suspicious – an offshore entity that had not been audited
and had suddenly been valued upwards by R500m. The
profits that year allowed directors to pay themselves R14m
in bonuses. Two years later that value had to be written off.
Shareholders, needless to say, were not pleased.
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Cash flow coverage ratio
This ratio is of most interest to lenders to a company,
like its banks and bond holders, who want to assess the
company’s ability to meet its financing costs every year.
The ratio compares total operating cash flows to the total
debt, expressed as a percentage:
Cash generated from operations x 100
total debt
Remaining with the Shoprite example, in 2014 cash
generated from operations was R5.72bn and total debt
was R4.7bn. That gives a cash flow coverage ratio of
122%. This is a very strong balance sheet as Shoprite can
effectively pay back all its debt and then some with one
year of operating cash flow. However, Shoprite has a large
amount of creditors in the form of suppliers, and it owes
them R16.3bn. If you include that as debt, the ratio falls
to 27%. That is less comforting and indicates that creditors
should be more cautious about Shoprite’s liquidity
position. If all its suppliers started demanding faster
payment, Shoprite could find it challenging to do so.
The cash flow coverage ratio is also useful to shareholders
because companies with a low ratio could be expected
to be cash conservative and probably limit investment
in growth or pay out cash to shareholders.
Free cash flow
Free cash flow is not a ratio, but can be used in a variety
of different analytical approaches to price a company.
It is important to investors as the figure indicates the
amount of cash available to distribute to shareholders
because it is the money remaining after a company has
settled all its obligations, including financing costs and
the costs of investing in plant and equipment to continue
operating at current levels.
of the business can call theirs – it is the cash that is surplus
to the needs of the business to keep its current operations
going. If it chooses to use some of that cash to fund its
growth, shareholders should be pleased provided that the
growth will be in ways that will add to profits and thereby
increase the cash flows shareholders get in the future.
Ultimately the value of any financial asset depends on the
cash flows it delivers to the owners of that financial asset.
It is calculated by deducting investing cash flow from
operating cash flow, except where the investing cash
flow is in new business areas. It is what the owners
9
Part 2.9 – Next we consider an important way of valuing companies
by discounting their free cash flows.
Click here for part 2.9
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Wealth and Investment Management
Stockbrokers
9
Smart Investor
Basic concepts used
in fundamental analysis
“Forecast periods can be of varying lengths, but it must be
remembered that cash flow estimates become less accurate
the further into the future you project.”
Part 2.9
Discounted cash flow valuations
In this note we discuss one of the most important methods of valuing shares: discounted
cash flow. It is a key way to figure out what a share is “worth” so that you can compare
it to the share price to look for value.
If you know you are going to get R1000 in one year’s time,
what is the current value of that cash flow? Obviously if you
could have R1000 now rather than in a year’s time, you’d take
it now, so something must compensate you for the wait.
One way to think of it is as an interest rate. If you could
get an interest rate of 11%, you’d deposit R900 in a bank
now in order for it to be worth R1000 in one year. You are
“buying” a future value of R1000.
The idea behind cash flow discounting is that there should be
a discount applied to future amounts to get a present value.
So for instance, if you used the discount rate of 10%, the
present value would be R900 to get the cash flow of R1000
in a year. We would say that you’d pay R900 now to receive
R1000 in a year, which implies a discount rate of 10%.
This is the basic idea behind the valuation of all shares
and other financial assets. All financial assets are basically
pieces of paper that give the holder a right to a future
stream of cash flows (although now those pieces of paper
are actually just electronic records). A bond gives you the
right to interest payments plus the return of the capital
amountat the end of the bond term. A share gives you
the right to a share of the profits of a company for as long
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as the company exists (and to its assets if it ever winds up).
Financial assets are distinct from other assets such as gold,
jewellery and artworks that don’t necessarily generate any
financial returns.
When undertaking cash flow analysis there are two big
questions that need to be answered:
1. How much are the cash flows that we will receive
in future?
2. What discount rate is reasonable to apply to those
cash flows to determine the present value?
There is no end to the discussion about ways to estimate
these two key measures, and we’re only going to give
a brief overview. Then we’ll explain the way financial
analysts calculate present value once these estimates
have been determined.
Snapshot
What is it? Cash flow discounting is one the key ways
to calculate the value of any financial asset. The principle
behind it is one of the most important ideas in financial
theory – that the value of any asset must be the present
value of its future cash flows.
Why is it useful? A discounted cash flow valuation
typically requires more effort than most relative valuation
techniques, but it provides a good picture of the key drivers
in the share price: expected growth in earnings, capital
efficiency, cost of equity and debt, and expected duration
of growth phases.
Estimating future cash flows
These estimates are especially important, and rather
complicated, but help to provide some clarity on a company’s
expected future profit. With the insights you’ve gained
in this series of notes, you are well-positioned to start
estimating how a company’s profits will grow in future.
The key issues to think about are:
Is the company in a growing market with increasing
product sales? Does it have the ability to increase prices
and margins? Is it investing in its own growth by expanding
production and does it earn a good return on equity (RoE)?
Also, is equity growing?
A company’s historic growth rate can give some indication
of future growth trends. This is part art, part science, but
an understanding of the profit drivers in a company and
the market it operates in allows investors to narrow down
the range of their projections.
Certain websites carry the consensus forecasts of analysts
who calculate expected earnings per share. These are
a good guide to forecasts.
Our focus is on estimating “free cash flow” which
we discuss in our previous note, number 2.8. That is the
cash that is surplus to the company’s needs to maintain
current operations.
Estimating the discount rate
Determining the discount to apply is essential to calculating
the future value of a company’s cash flow.
Two factors will determine the extent of that discount. Firstly,
the prevailing interest rate because the return from investing
in a company’s shares has to be higher than a risk-free
deposit in a savings account.
The second factor to consider is the risk inherent in investing
in a particular company. Companies with highly volatile
earnings and big risks to future profits should compensate
you for those risks, which can be determined to some extent
by looking at historic share price movements. If a share price
has been very volatile we assume the company is very risky.
Bearing these factors in mind then, an investor can apply
a higher discount on future cash flows when both the
interest rate and risks associated with a company are higher.
The discount rate indicates the expected return from an
investment. So, once you have estimates of cash flow and the
discount rate, you can calculate a present value for a financial
asset. If this present value is above the share price, you buy,
and conversely if it is below the share price, you sell.
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Trading insight
A key advantage of this type of valuation is that they
are less likely to be affected by earnings manipulation
or aggressive accounting as they are based on cash flows,
which are hard to manipulate. This valuation is useful
for comparing companies with diverse capital structures.
The discounted cash flow (DCF) calculations
Here’s the formula to use to make these calculations.
It looks complicated, but it contains a simple idea!
Essentially, what this formula says is that the present value
is the sum of each year’s free cash flow, discounted by the
discount rate:
Here is an explanation of what the various abbreviations
represent:
Here are the two basic ideas:
Free cash flow (FCF) – Cash generated by the business
available for distribution to all providers of capital (debt
and equity).
Discount rate (r) – The rate used to discount projected
FCFs and terminal value to their present values.
Growth rate (g) – The rate at which free cash flows
are projected to grow into the future.
1. All that matters when owning a financial asset is the
cash flows that ownership gives you access to. The tricky
bit is figuring out just what those cash flows will be. In the
case of equity (rather than debt), future cash flows are
less certain.
2. Before making an investment, you should ensure that
the yield from that investment compensates you for the
risk. The more certain you are about the cash flows, the
less you need to demand to make the investment.
The DCF formula determines the total enterprise value. From this number we have to deduct
total debt, the part of the enterprise value that is “owned” by the debt providers. Whatever
is left after that is owned by the shareholders. That number can be divided by the number
of shares in issue to obtain a value per share. That is the key number to compare to the market
price to tell if it is worth buying.
Some more insight into making estimates
It is important in the first step to determine the forecast
time period and expected number of phases. For example,
you might identify two stages of growth: a high growth
stage and thereafter a low growth phase; or you may
use a three-stage growth phase with three periods: high,
moderate and low growth.
Forecast periods can be of varying lengths, but it must
be remembered that cash-flow estimates become less
accurate the further into the future you project. So an
estimated terminal value is as good as trying to make
yearly estimates.
The quality on the inputs in the valuation will determine
the quality of the output, and unfortunately the process
is not a simple case of inputting the numbers into the
formula because subjective projections and some
assumptions are required.
The discount rate that results from the calculation
is the rate at which the free cash flow in each of the periods
is discounted to a present value. This can also be expressed
as a discount factor, which is a single figure by which each
cash flow is multiplied to arrive at a present value.
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The good
You cannot know whether a company’s share is undervalued
or overvalued until you have analysed it, and a DCF valuation
method is one of the most important methods of estimating
a company’s intrinsic value. This method of valuation
can be checked against other valuation techniques, such
as relative valuations derived from such measures as the
price-to-earnings, price-to-book value multiples, and other
valuation methods we have discussed in previous Smart
Investor notes.
While a DCF valuation typically requires considerably
more effort than most relative valuation techniques
(like price to book or price to earnings ratios), it does
provide a good picture of the key drivers in the share
price: expected growth in earnings; capital efficiency;
balance sheet capital structure; cost of equity and debt;
and expected duration of growth phases.
The bad
DCF is only as good as the estimates that are made.
The further into the future one is trying to estimate,
the less accurate the results are going to be. Present values
are also highly sensitive to the discount rates that are
estimated. The vast majority of analysts’ estimates
turn out to be quite wrong.
The bottom line
DCF is always a worthwhile exercise even if it is quite hard
work to do properly. At the very least it reveals what the
market currently believes about future earnings, which can
help you make judgment calls over whether the share price
represents value or not.
10
Part 2.10 – Next we discuss important issues in thinking
about a company’s risk level.
Click here for part 2.10
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Wealth and Investment Management
Stockbrokers
10
Smart Investor
Basic concepts used
in fundamental analysis
“In common usage, “risk” refers more to the fear that we could
lose some or all of our investment, not how a share price
gyrates around the average return.”
Part 2.10
Profiting from risk (a)
We have focused mainly on fundamental analysis so far in this series, looking at how to calculate
expected returns. The other crucial factor in any investment decision is risk and there is invariably
a trade-off between risk and returns. Any investment offering wondrous returns probably carries
much higher risk than an investment that promises low returns.
This is the first of a two-part series focused on understanding risk, measuring it and learning
how to profit from it. We start with analysis of equity market risk, and the all-important measure
called Beta.
Snapshot
What is it? The probability that you are actually going
to get the returns you expect.
Remember: This trade-off between risk and return is a key
feature of investments and has been implicit in much of
the discussion in the previous Smart Investor notes.
A useful rule of thumb: The higher the expected returns,
the higher the risk.
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Risk and investment
The use of statistics to analyse financial decisions was
introduced for the first time by economist Harry Markowitz
in the 1950s. He took the concept of volatility from statistics
and used it to explain how investment decisions can be
optimised by treating volatility the same as risk.
Markowitz showed that it is not just returns that
matter, but the volatility of returns. Investors should aim
to maximise returns but minimise volatility, and portfolios
can be constructed to do this efficiently. That insight
earned him a Nobel prize decades later.
A share that has big swings up or down of, say, 10%
each day is a highly volatile one. A share that has swings
of less than 1% is far less volatile. This seems to capture
something about what we mean when we think of
risk. A highly volatile share tends to keep an investor
a tad stressed.
A clear example of this is reflected in the chart below
showing the daily movement in the share price of Sibanye
Gold versus the All Share Index. Each red dot shows the
movement in the closing price of the share. In the period
covered, there a numerous days with a swing of nearly 10%
both up and down, while there are three days with a swing
down of 10% or more and one day with a swing up of 10%.
It is clear that Sibanye Gold is more volatile than the All
Share Index (green dots).
Risks: low and high
A bond is a low-risk investment – it pays a fixed amount
of interest that is usually quite low. At the other end of
the scale are high-risk equity investments such as mineral
exploration companies that could make a fortune if they
strike oil but are worthless if they don’t. This range
of risks can be multiplied or lessened through the
use of derivatives.
15%
10%
5%
0%
-5%
-10%
-15%
Jan-13
Mar-13
May-13
Jun-13
Sibanye Gold
JSE Alsi
Aug-13
Oct-13
Daily returns of Sibanye Gold (blue) versus the All Share Index (red)
In common usage, “risk” refers more to the fear that
we could lose some or all of our investment, not how
a share price gyrates around the average return. Certainly
we don’t consider the possibility that returns will be too
high as a risk factor. But statistical volatility is a measure
of dispersion around the mean – whether it is up or down.
That is why there is a trade-off between risk and return –
volatile returns tend to average out at a higher rate over
time than non-volatile, stable returns.
Fundamental analysis has many different way of thinking
about financial risks. These include how a company
manages risks it faces, such as credit risk, exchange rate
risk, commodity price risks, interest rate risk, liquidity risk
and so on. Of course, there are also non-financial risks such
as the risk of a factory burning down, and part of analysing
a company is checking to ensure that it can manage those
risks through insurance and other tools. In the next Insights
article on risk we will take up some of these issues.
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Equity market risk
Markowitz’s idea was to create “efficient portfolios”
by combining different assets to minimise variance
(a kind of volatility) at the same time as maximising
return. “Efficient” meant you couldn’t get any more
return without sacrificing some variance, or get less
variance without sacrificing some return. This relies
explicitly on the concept of a trade-off between risk
and return. The problem with Markowtiz’s approach
is that even once you understand the volatility of an
individual asset, you’d need to work out how volatile
all the possible asset combinations would be. Each
combination is a possible portfolio and each portfolio
has a unique profile stemming from the covariance
of the assets within it. Computers at the time couldn’t
handle the calculations.
In the 1960s, one of Markowitz’s protégé’s, William
Sharpe, developed what we now call the Capital Asset
Pricing Model. It drew on Markowitz’s idea of volatility
but produced a simplified approach to managing it.
Sharpe began with a basic assumption: the market itself
is the most efficient portfolio – every single available asset
in a single portfolio. The JSE’s All Share Index (Alsi), would
be taken as the market, as it includes all eligible listed shares.
The question then is how an individual asset correlates with
the volatility of the Alsi – is it more or less volatile?
This question is answered by a measure called Beta, which
also comes from statistics. Its mathematical formula is:
It may look complicated but the idea is simple: Beta is the
covariance of the returns from a particular asset with the
returns of the market
.
It measures how closely volatility in the returns track each
other – divided by the variance of the market as a whole
.
The number comes out as 1 if the asset is just as volatile
as the market. A Beta of 1.1 means the asset is 10% more
volatile than the market, while a Beta of 0.8 means it is
20% less volatile than the market.
The important idea of Beta is that it measures the risk that
cannot be diversified away without sacrificing returns.
A high Beta stock therefore must be one that offers higher
returns than the market and a lower Beta stock must offer
returns lower than the market. It is important to remember
that the market itself is still volatile. All Beta is saying is
how a particular investment should perform relative to
the market as a whole. It is only a relative, not an absolute,
measure of risk.
By looking at the Beta we can then get an idea of just
how much return we should expect to receive for holding
a particular stock. That is the essence of Sharpe’s Capital
Asset Pricing Model.
Beta
The underlying theory in using Beta stems from the efficient
markets hypothesis, which says share prices really do reflect
the actual risk in that stock. While that is debatable, the way
we like to think of Beta is as a reflection of more fundamental
risks in a company.
We know from previous notes that a share price is merely
the present value of future cash flows of that company.
So changes in the share price (volatility) should reflect
changing views over what the future cash flows will
actually be. A utility company that has a monopoly and
whose customers have little choice but to buy its output
will have a very predictable cash flow stream and therefore
a low Beta. Pharmaceuticals and mining exploration
companies, though, depend on big discoveries in order
to generate profits, so can be highly volatile and therefore
have a high Beta. High Beta stocks are also those which
have high financial leverage or high fixed costs relative
to variable costs, and so struggle to absorb changing
market conditions.
Control risk with Beta
What is important is that Beta is a useful way to control
risk in a share portfolio. If we want to lower risk then we
add low Beta stocks, or add high Beta stocks to increase
risk. Low Beta stocks are better if you are expecting
a recession, whereas high Beta stocks are better
if you are expecting a market rally.
Risk in Beta
We measure Beta by looking at historic return figures
and applying the statistical tools to them. It does not
look forward. Immediately this raises problems with
some stocks – for example, if a company is a takeover
target, its share price tends to shoot up to the level at
which the offer is made, or collapse if the deal does not
happen. In such a case, past volatility has little bearing
on future volatility.
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Finding Beta
It is not hard to calculate Beta using the formulas above
and Excel, but Beta is often provided by various financial
data websites, such as the Reuters website where
it is available for free.
11
Part 2.11 – In our next note we discuss risk and the Sharpe ratio.
Click here for part 2.11
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Wealth and Investment Management
Stockbrokers
11
Smart Investor
Basic concepts used
in fundamental analysis
“Good investors understand the trade-off between risk
and return and aim to maximise it.”
Part 2.11
Risk and the Sharpe ratio (b)
In Smart Investor 10, we learnt to see risk as an essential component in any share’s expected
returns. The important point is that we should expect to be compensated with higher returns
for taking on extra risk.
Snapshot
What is the Sharpe ratio? It tells us how much
risk an investor took on for the return earned.
Why it’s useful: The Sharpe ratio is often used as a way
to assess professional investors as it reveals how well they
manage risk.
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Managing risk
The previous note showed how risk and return stand
in opposition to one another. Risk is determined from
Beta, a statistical measure of the relative volatility of
an asset compared to the market as a whole, or volatility
which measures the risk of a share in absolute terms.
Good investors understand the trade-off between
risk and return and aim to maximise it.
In order to assess how investors are doing, we use a tool
called the Sharpe ratio, named after the economist who
invested the Capital Asset Pricing Model in the 1960s
(he called it the “reward-to-variability ratio”). The ratio
is often used as a way to assess professional investors
as it reveals how well they manage risk. It is often used
to assess unit trust fund managers, for example. The ratio
tells us how much return the investor earned for the amount
of risk taken on. Minimising risk while maximising returns
is an important objective. If two fund managers achieve
the same returns, you’d want to be with the one that took
on less risk.
The Sharpe ratio
The Sharpe ratio tells us how much return is generated
for a given unit of risk. As we discussed in the last note,
a “unit of risk” is the standard deviation of the returns
of an investment. Standard deviation is the distribution
of returns around the average return. So if the share delivers
an average daily return of 0.5%, but often varies significantly
from that, then the standard deviation is higher than a share
that consistently delivers 0.5%. A share with a high
variance (variance is just standard deviation squared)
is considered higher risk than one with low variance.
Once we have the standard deviation of the share we
then consider the returns and how much excess returns
are earned per standard deviation.
The Sharpe ratio’s formula is:
ri – rf)
i
(which is the rate of interest we could earn for taking no
risk at all – i.e. putting it in a bank deposit or a government
retail bond), divided by the standard deviation of the).
We won’t go into how to calculate standard deviation
in this note, but it is easily researched online and can
be calculated using an Excel spreadsheet. It is usually
expressed in percentage points, reflecting how much
the returns vary from the mean. So the ratio tells us how
much in excess returns an investment has generated for
each percentage point of standard deviation. The higher
the ratio, the better the investment.
Looking at the returns per unit of risk enables us to compare
investments that have very different risk profiles. A portfolio
of small-cap shares, for instance, will have a higher standard
deviation than a portfolio of government bonds, but the
returns per unit of standard deviation may still be higher,
making the small-cap portfolio a better investment.
The Sharpe ratio is particularly useful for assessing
portfolios, because it can draw out the skill of the
portfolio manager in combining investments so as to
lower the overall volatility of the portfolio. The ultimate
aim is an “efficient portfolio” – one that could not be any
less risky without giving up some returns, or deliver no
higher returns without adding some risk. We can compare
managers by looking at the Sharpe ratio, especially when
the two managers have the same investment mandate
and available investment instruments.
Examples
You can, however, also use the Sharpe ratio to look at the
returns of individual stocks. We’ve done that for a few
popular South African shares in the table below.
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Share
Average annual return
Standard deviation
Sharpe ratio
Naspers
37.83%
36.53%
0.87
MTN
15.26%
13.49%
0.68
FirstRand
10.34%
25.71%
0.17
BHP Billiton
4.95%
17.56%
-0.06
Standard Bank
3.43%
15.44%
-0.17
Anglo American
-8.74%
21.30%
-0.7
(Based on annual returns. Source: Intellidex)
So the Sharpe ratio tells us that, for example, Naspers
earned 0.87 percentage points of return for each standard
deviation. Naspers is therefore the most efficient stock
on the list in terms of its risk/return ratio.
Variations to the Sharpe ratio
William Sharpe won the 1990 Nobel Price for the
Capital Asset Pricing Model. In 1994 he went further:
he decided we should rather be looking at standard
deviation of returns over the investor’s benchmark.
So if a fund manager is being measured against a
benchmark’s returns, his fund’s risk should also be
measured relative to the risk in the benchmark. Most
managers, however, still use the original Sharpe ratio.
Another useful variation is called Roy’s ratio. This defines
the top part of the equation (numerator) as the returns
above a given minimum return, rather than returns above
the risk-free rate. This is useful if you have a particular return
objective such as being able to fund your retirement. Roy’s
ratio allows you to see how efficient the manager is being
at using your portfolio to generate excess returns: a bonus
to the minimum returns you need for your investment goal.
Problems with the Sharpe ratio
Like much of financial analysis, it rests entirely on historic
data. What a share has done in the past is not necessarily
what it is going to do in the future. Past performance may,
however, give us some useful insight into the nature of the
share. One with a low standard deviation usually reflects
a company with reliable and predictable earnings. But it
is always important to think about how reliable the past
performance is as a guide to the future. A company that
makes major changes, such as an acquisition, will probably
have a different risk profile in future.
There are also problems with the use of standard
deviation as a measure of risk. The technique makes
some assumptions about how returns are distributed,
what is usually called the “normal” distribution, which
assumes, among other things, that returns are symmetrical;
i.e. that returns deviate from the mean upwards just as often
and by just as much as they do downwards. But we know
in fact that share prices tend to fall faster than they rise.
Final thought
We have mentioned just some of the variations
to the Sharpe ratio here – there are others that have been
developed in an attempt to compensate for weaknesses
in the Sharpe ratio. However, the Sharpe ratio remains one
of the most commonly used methods in finance today
to assess performance. While it would be worthwhile
using it on your own investments, it is definitely something
that should be used to examine the performance of any
professionally managed investment portfolio such as a unit
trust, especially to compare it with competitors.
This is the last of the series of advanced notes in the Smart Investor
education series. We hope you’ve enjoyed them!
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